Unit II. Measurement of Economic Performance

Click picture to view source.

A. 1. This is circular flow. The circular flow model shows the flow of money through an economy. Starting with households, the households buy products from the product market (such as walmart). The households pay money to the product market, which then pays the firms for the products bought with money. The firms need factors of production in order to produce, so they must pay wages, rent, etc. to the factor market in order to get the factors. The factors are supplied by households, who receive the payments and then are able to buy more products. In the middle of everything (literally and figuratively), the governments and financial institutions play a role. When households buy products, own land, get wages, etc, they must pay taxes to the government. In turn, the government pays the households transfers (like Social Security, Disability, Food Stamps). The households also pay money into the financial institutions in the forms of savings and loan payments. From savings and other deposits (such as CD's), the households receive payments in the form of interest and dividends. Firms take out loans from the financial institutions in order to improve capital, and so pay in interest and the loan principles. Firms face the same situation with the government as the households do: payments in for taxes and payments out for transfers. When the circle goes the other way, it shows the labor market. The households supply labor to the factor market, which supplies labor to the firms. The firms supply products to the product market, which supplies products to the households.

2. Gross Domestic Product:

Gross Domestic Product (known as GDP) is a monetary measure of all final goods and services produced within the borders of one country in one year. If the japanese have a Toyota plant in Chicago? It's counted in the U.S. GDP. GDP DOES NOT INCLUDE INTERMEDIATE GOODS. Intermediate goods= goods and services purchased for resale or further processing or manufacturing. A car is a final good, it is counted in GDP. It will be used for resale later when it is traded in or sold used, but that value is not counted into GDP. The steel used to make the car is also not counted into GDP, because it is not the final good produced.

Things that are included in GDP:

"Consumption expenditures: Personal consumption expenditures on goods and services comprise the largest share of total expenditure. Consumption good expenditures include purchases of nondurable goods, such as food and clothing, and purchases of durable goods, such as appliances and automobiles. Consumption service expenditures include purchases of all kinds of personal services, including those provided by barbers, doctors, lawyers, and mechanics.

Investment expenditures: Investment expenditures can be divided into two categories: expenditures on fixed investment goods and inventory investment. Fixed investment goods are those that are useful over a long period of time. Expenditures on fixed investment goods include purchases of new equipment, factories, and other nonresidential housing as well as purchases of new residential housing. Also included in fixed investment expenditures is the cost of replacing existing investment goods that have become worn out or obsolete. The market value of all investment goods that must be replaced in a single year is referred to as the depreciation for that year. Inventory goods are final goods waiting to be sold that firms have on hand at the end of the year. The year-to-year change in the market value of firms' inventory goods is considered an investment expenditure because these inventory goods will eventually yield a flow of consumption or production services.

Government expenditures: Government expenditures on consumption and investment goods and services are treated as a separate category in the expenditure approach to GDP. Examples of government expenditures include the hiring of civil servants and military personnel and the construction of roads and public buildings. Social security, welfare, and other transfer payments are not included in government expenditures. Recipients of transfer payments do not provide any current goods or services in exchanges for these payments. Hence, government expenditures on transfer payments do not involve the purchase of any new goods or services and are therefore excluded from the calculation of government expenditures.

Net exports: Exports are goods and services produced domestically but sold to foreigners, while imports are goods and services produced by foreigners but sold domestically. In the expenditure approach to GDP, expenditures on exports are added to total expenditures, while expenditures on imports are subtracted from total expenditures. Alternatively, one can calculate net exports, which is defined as expenditures on exports minus expenditures on imports, and add the value of net exports to the nation's total expenditures." Link to Source

Things that are NOT included in GDP:

"a. Non-marketable goods and services: tasks that do not involve market transactions, such as baby sitting, house cleaning, lawn mowing etc. Some very useful output is excluded because it is unpaid employment. b. Underground activities: illegal or cash transactions have no record. Government’s estimates on these transactions are not accurate.
c. Sales of used items: GDP measures only current output. Used car and thrift stores’ transactions are not counted.
d. Financial transactions: trading existing assets, such as stock or bond purchases.
e. Transfer payments: either government or private transfer payments are not included because goods and services are not produced in this process. Examples are social security benefits or kid’s allowances.
f. Leisure: individuals consume leisure, just as they consume all the other tangible goods, which generate satisfactions. But leisure has no price tag, so it is not included in GDP.
g. Social costs: production processes may cause pollution. Polluted air and water may have social costs like bad air quality, and cancer patients. These social costs reduce our economic well being. If money is not spent to clean up the oil spill or to cure the cancer patients, those expenses are not added to the GDP.
h. GDP does not measure quality or nature of the product, which contributes to the satisfaction level of the consumers. Nominal GDP simply adds the dollar value of the product; it makes no differences if the product is a weapon, or a book." Link to Source

3. Components of GDP: A simplified equation for the exponenture view of GDP: C+I+G+(X-M) or Consumption+Investments+Government expenditures+(Exports - Imports) (SEE ABOVE FOR EXPLANATIONS)
4. There are two types of GDP: Nominal and Real. Does this mean one is imaginary? Maybe, I mean, really.. its economics. Otherwise, no. Nominal GDP is GDP based on current output at current prices. While it gives the level of output of the country, GDP can also rise because of rising prices due to inflation. If a cookie costs $1 in one year, and $2 in the next, the next will have a higher nominal GDP because of the price rising. This fact makes nominal GDP a tool that is barely used. In typical economics, when referring to GDP, one uses real GDP( A.K.A. RGDP). RGDP is nominal GDP divided by the price level (discussed later). Real GDP gives the level of output in a base year's prices, which shows actual growth (or lack thereof). RGDP is a much better tool because it gives a real idea as to the current national situation. Also, graphs (such as the aggregate demand/supply graph) uses RGDP instead of nominal.

B. Inflation measurement and adjustment
1. Price Index- (according to dictionary.com) is " an index of the changes in the prices of goods and services, based on the prices of the same goods and services at a period arbitrarily selected as a base, usually expressed as 100." In lamens terms, this means that it is a measurement of price changes. "They" use a select bunch of standard goods in a "basket" that looked at for prices.

The most common price index is the Consumer Price Index. According to Investopedia.com: it is "a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living."

Equation for CPI:

CPI= frac{text{updated cost}}{text{base period cost}} times 100

2. Inflation- Inflation is the change in a price level. The price level for one year is given by the CPI calcuation. Inflation is usually seen as an increase in the price level, while negative inflation(or a decrease) is known as deflation. When inflation occurs, all prices in the spectrum of a nation rise equally.Equation for inflation:

inflation rate

3. As aforementioned, there are two different types of values when calculating monetary values of measurements in economics, the nominal value and the real value. The nominal value gives you the calculation as it stands now. It includes inflation and does not effectively give a measurement, because prices and wages may change, but outputs other values do not, which is turn changes measurements. A real value, however, takes into account the changes in inflation and so gives better measurements, which show true growth or decay of measurements in a nation. For example, if one is given nominal GDP for the US in 2005, in order to calculate the RGDP and determine if growth/decay occured, one must determine the price level and then divide the nominal GDP by this level. This will give one RGDP.
4. Costs of Inflation (This site was used as a reference).

Changes in imports and exports: When inflation occurs, foreign products seem better because they are cheaper relative to the prices in the nation. This will lead to a rise of imports. While foreign nations seem better, domestic prices ward off foreign consumers and so this will decrease exports. With higher imports and lower imports, RGDP for a country will fall.

Confusion of consumers: When inflation occurs, people are uncertain as to how to utilize their money. Should they keep their expensive phone plans or save more money in case more inflation occurs?

Menu Costs: Costs occur to producers and sellers when they have to change their prices. They must spend money to buy new papers and labels and also takes up some time they could have been using to sell more products.

Shoe Leather Costs: This is the cost of bank runs during inflation, when people want to try to save more money in order to minimize losses due to inflation. The people must take time out of their day and also do literally cause wear to the shoes.

Income redistrobution: When one takes out a loan, a choice is usually given: fixed or variable rate loans. A fixed rate does not allow for changes in the price level, while variable rate loans do. If the price level decreases, interest rates decrease and so loans become cheaper because one is paying less out in interest+ the pricinple, while one with a fixed rate loses out, because they are still paying the same and do not get to see a decrease in the amount they are paying. When inflation occurs, a variable rate loan will increase the amount that is owed because more interest is added to the payment. With a fixed loan, one wins because they are now paying the same amount they were and do not have to pay more back due to inflation. Also, the principle loses value due to inflation, and so makes the fixed-loan person win even more ($20,000 is equal to $30,000 after inflation, perhaps).

Boom and bust economic cycles: A period of high inflation, or even hyperflation (a period of rapidly increasing inflation), is usually followed by a recession. Recessions are not fun. They pose higher costs and living and lots of sadness.

Costs of reducing inflation: In order to reduce inflation, the government must decrease spending while the Fed (Federal Reserve) decreases the money supply via open-market operations. These actions will reduce inflation, but at the same time will inhibit growth.

Unemployment!

That it does... (Click picture for link)

What IS unemployment? Unemployment is "when a person who is actively searching for employment is unable to find work. Unemployment is often used as a measure of the health of the economy. The most frequently cited measure of unemployment is the unemployment rate. This is the number of unemployed persons divided by the number of people in the labor force." (Investopedia) Unemployment is measured by the US government. Unemployment is the sum of all unemployed persons, although not all unemployed people are not included. Housewifes, people who have tried to look for work but cannot find it (discouraged workers), and people who have not worked within the last four weeks are not counted in unemployment. There are different specific types of unemployment:

Frictional Unemployment - this is when people are between jobs or are in one job and looking for another.

Structural Unemployment- the mismatch between jobs and skills. A person who is replaced by a computer is now structurally unemployed.

Cyclical Unemployment - "A factor of overall unemployment that relates to the cyclical trends in growth and production that occur within the business cycle. When business cycles are at their peak, cyclical unemployment will be low because total economic output is being maximized. When economic output falls, as measured by the gross domestic product (GDP), the business cycle is low and cyclical unemployment will rise. Economists describe cyclical unemployment as the result of businesses not having enough demand for labor to employ all those who are looking for work. The lack of employer demand comes from a lack of spending and consumption in the overall economy." - (investopedia)

Seasonal Unemployment- This is exactly what one would think it is- being unemployed because of seasons. A snow plower cannot plow snow in the summer, and a road worker will have trouble working on roads when they are covered in snow or in a temperature of -10000 degrees.

Natural Rate of Unemployment-

Yes, there is a such thing as a natural rate of unemployment. Not everyone can have a job at one time. Also, people are constantly looking for new jobs as time goes on, while there is always structural unemployment, too. The world is constantly changing and so technologies become more advanced and people get mismatched with jobs. The natural rate of unemployment is about 5-6%. This is also known as "full employment," which is discussed more in the topic of aggregate supply and demand and equilibrium.

"The lowest rate of unemployment that an economy can sustain over the long run. Keynesians believe that a government can lower the rate of unemployment (i.e. employ more people) if it were willing to accept a higher level of inflation (the idea behind the Phillips Curve). However, critics of this say that the effect is temporary and that unemployment would bounce back up but inflation would stay high. Thus, the natural, or equilibrium, rate is the lowest level of unemployment at which inflation remains stable. Also known as the "non-accelerating inflation rate of unemployment" (NAIRU)."